Two Statutes Collide - 363 Fights it out with 365.

Probably the most commonly heard Motion in Bankruptcy Court is a Motion for Sale Pursuant to 11 U.S.C. §363(f). This section, generally, allows the Trustee (or Chapter 11 debtor) to sell property free and clear of liens, generally providing that liens will attach to proceeds in the same rank, validity and priority. This section allows a debtor to rid itself of property that might have some value but is not essential to its reorganization. More often, this section allows a Bankruptcy Trustee to marshal the equity of what would otherwise be non-exempt real estate.

This is all fine and good except in the very rare instance where a debtor owns real estate and leases a part of it to a third-party. In most instances, this does not occur – debtors are lessees, they rent from real property owners, rather than the other way around. However, §365(h) gives a third-party lessee (that is, someone renting from a debtor) special protections, i.e., the lessee has the right under 11 U.S.C. §365(h)(1)(A)(ii) to “retain its rights under the lease, that is, continue by paying its rent and otherwise complying with the terms of the lease, to stay in possession through the remaining term. So, what happens when the Chapter 11 debtor or a Chapter 7 Trustee wishes to sell a parcel of real property part of which (or all of which) is subject to a lease? Two Circuits have addressed this issue. Most recently the 9th Circuit and In re: Spanish Peaks Holdings II LLC, 872 F3d 892 (9th Cir., 2017). In Spanish Peaks, the Court rejected what was generally believed to be the “majority approach” which held that “the specific prevails over the general” and that because §365(h) specifically gave rights and privileges to the lessee, it prevailed over the right of the Trustee to sell the property completely free and clear of liens and encumbrances, including the lease.

In it’s analysis (which this writer agrees), the Court followed Precision Industry, Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp. & Qualitech Steel Holdings Corp.), 327 F.3d 537 (7th Cir. 2003) and found the correct answer to the problem at hand. Noting that 11 U.S.C. §363(e) specifically allows parties, including lessees, to seek “adequate protection” (in the event of a sale), the two statutes were not really in conflict. The lessee was entitled to the “indubitable equivalent” of its lease. See, 11 U.S.C. §361(3). As such, provided that the compensation awarded to the lessee was proper, the property could be sold free and clear of liens and the two statutes were reconciled.

Note: This case, which now appears to be guiding a new majority, does propose some practical issues. How does one determine the “indubitable equivalent” of a long-term lease for say, a restaurant or other commercial establishment? Is it the reasonable profits over the length of the lease reduced to a present value? Might there be intervening events in the future that could reduce the present value? These issues were not developed in either Spanish Peaks or Qualitech. We await discussion as the case law evolves on this issue.

Categories: Bankruptcy

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